Statement on Monetary Policy – August 2007
Economic data in Australia over recent months have signalled a pick-up in the pace of growth in demand and activity. Capacity utilisation is high after a lengthy period of expansion, and business and consumer confidence are strong. These conditions have been accompanied recently by higher-than-expected underlying inflation.
Growth of the Australian economy has for some time been assisted by favourable international conditions. Current expectations of official and private-sector observers are that the world economy will continue to grow at an above-average pace in both 2007 and 2008. These expectations have generally been revised upwards over recent months, with slower growth in the United States expected to be more than offset by stronger growth in China and the other major economies.
Notwithstanding the strong overall performance of the world economy, international financial markets have experienced significant volatility in recent weeks, primarily stemming from the sub-prime mortgage market in the United States. Delinquency rates in that market have been rising over the past year reflecting a marked decline in lending standards, particularly in 2006, and the expiration of discounted interest rates applying for the first two years of many of these loans. The mortgage-backed securities and the associated collateralised debt obligations based on these loans have suffered sharp falls in prices, exacerbated by a lack of liquidity in these markets. This in turn has generated problems for the holders of these products, particularly those who had used leverage.
There has been some flow-on through credit markets, where spreads have widened, particularly for low-rated paper. However, at this stage, the extent of the widening has only seen spreads rise back to more reasonable levels after a period when risk appears to have been under-priced. Yields on highly-rated government paper have declined, reversing much of the rise seen in May and June. Equity prices have also fallen, with the shares of financial institutions suffering the largest declines. Both bond and equity markets have experienced a marked increase in volatility following a number of years when volatility had been low.
The extent to which these financial events might affect global growth remains uncertain. The main risk would appear to stem from the possibility of an excessive withdrawal of the provision of credit, which could constrain growth in spending and output, particularly in the United States. At this stage, however, the evidence continues to point to strong growth in the global economy overall. While there has been a slowing in the United States, this has so far been largely confined to the housing sector, with the wider economy still growing at a reasonable pace. The US national accounts showed a pick-up in GDP growth in the June quarter, and employment has continued to expand at a pace broadly in line with the growth of the labour force. Indicators of performance in the manufacturing sector have picked up over recent months.
Strong conditions are generally prevailing in other parts of the world. China has reported a further step-up in its growth rate, to a pace of around 12 per cent. In Japan, although recent indicators have been quite volatile, a reasonable pace of expansion seems to have continued, with employment and business sentiment both remaining firm in the June quarter. The smaller east Asian economies for which June quarter national accounts are available have reported strong growth rates. There are also indications that industrial production and exports across the region have firmed in recent months in response to stronger demand from China and elsewhere. In the euro area, recent data suggest that growth has continued at a firm pace through the first half of the year, though conditions are not as strong as they were last year.
Consistent with the strength of the world economy, global commodity prices have remained high in recent months, and in some cases have strengthened further. Analysts’ forecasts of contract prices for Australia’s bulk commodity exports have generally been revised upward, reflecting further increases in expected demand from China. Oil prices have picked up further. The cumulative increase in world commodity prices over recent years remains an important source of stimulus to Australia’s national income and spending.
The continued strength in commodity prices, together with higher interest rates in Australia than abroad, helped underpin the Australian dollar’s rise to multi-year highs against the US dollar and on a trade-weighted basis in July, before the currency depreciated somewhat following the disturbances in credit markets. It has also contributed to the larger increase in the Australian stock market than in other major markets, as the share prices of resource companies have been particularly strong. While the Australian share market and bond market have largely tracked global markets in recent weeks, this had little impact on expectations of a change in the cash rate. Financial markets had attached a high probability to an increase in the cash rate at the August Board meeting since the release of the June quarter CPI.
Information on the Australian economy in recent months has confirmed that the pace of growth in demand and activity has strengthened since around the middle of last year. Non-farm GDP is estimated to have grown by 4.6 per cent over the year to the March quarter, with overall GDP growing by 3.8 per cent. While some allowance needs to be made for the inevitable quarterly volatility in these figures, the broad picture from the national accounts accords with a range of other information pointing to above-average growth in the non-farm economy. Labour market indicators have been strong, with employment continuing to expand at a fast pace over the past year while the unemployment rate has declined. Business surveys in recent months have continued to report very favourable conditions consistent with above-trend growth. Prospects for the farm sector have also improved this year following good rainfall in the eastern states over the past few months. Much will still depend on the extent of follow-up rains but, at this stage, ABARE forecasts released in June are for a significant recovery in farm output, which is expected to add about ½ percentage point to overall GDP growth in 2007/08.
Growth of the Australian economy is continuing to be driven by domestic demand. Consumer spending picked up noticeably over the year to the March quarter, and the most recent indications are that retail sales have remained firm and that consumer confidence is high. With the exception of housing construction, all the other main components of domestic spending have shown strong growth over the past two years. As has been the case for some time, a significant part of the growth in domestic demand has been met by growth in imports. Export growth has remained relatively modest in aggregate, partly as a result of the drought. There has been some pick-up in resource exports in recent quarters, though the main effects from capacity expansions in the mining sector are still to be seen.
Notwithstanding the increases in interest rates that took place last year, the demand for finance strengthened in the first half of 2007, particularly in the business sector. Over the six months to June, business credit outstanding grew at an annualised rate of 22 per cent, up from a rate of 15 per cent at the end of last year. Businesses have also had ample access to other sources of external finance through debt and equity markets, though it is too early to tell yet the extent to which this financing activity will be curtailed as a result of recent market volatility. In the household sector, information for the first five months of this year suggested a modest pick-up in demand for finance, with household credit rising at rates of around 1 per cent a month, a little higher than at the end of 2006. The rate of increase picked up sharply in June, though this appears to have been boosted by borrowing to fund superannuation contributions ahead of rule changes at the end of that month.
Conditions in the established housing market generally appear to be firming, though there remain significant variations across different parts of the country. A range of estimates of average house prices showed a pick-up in nationwide prices in the June quarter. Sydney prices increased moderately, and there were strong increases recorded in Melbourne, Brisbane and Adelaide. Perth prices have been broadly flat after their earlier sharp increases. Strength in the upper end of the Sydney and Melbourne markets is indicated by rising auction clearance rates, which have recently been above average in both cities.
The continuing expansion over recent years has brought the Australian economy to a position where surplus productive capacity is rather limited. Businesses have been reporting their highest levels of capacity utilisation since the late 1980s. Unemployment in recent months has reached a generational low and a range of indicators including job vacancies, business survey results and liaison reports point to a scarcity of suitable labour. High levels of business investment can of course be expected to add to the growth of productive capacity over time. Nonetheless, with the economy currently growing at a higher-than-average pace, capacity pressures are likely to persist in the near term. There is little sign yet that these pressures are leading to any generalised pick-up in wages growth, although strong wage increases are occurring in industries facing particular labour scarcity such as construction and mining. Prices data, however, have indicated a pick-up in inflation recently.
The consumer price index for the June quarter showed an increase in quarterly inflation in both headline and underlying terms. The headline CPI rose by 1.2 per cent in the quarter and by 2.1 per cent over the year. In interpreting these figures it is important to note that the CPI in recent quarters has been influenced by some sharp fluctuations in fuel and food prices, and so the headline figures at present are a poor guide to the underlying trend. The quarterly CPI increase was boosted by a rise in petrol prices, while the year-ended figure of 2.1 per cent was held down by a sharp fall in banana prices from their spike a year ago. The Bank’s measures of underlying inflation, which seek to remove these temporary influences, show an increase of 0.9 per cent in the quarter and 2¾ per cent over the year, higher than was incorporated in the forecasts presented in the May Statement. The June quarter result reflected broad-based increases across a range of items in the CPI.
In its policy deliberations over recent months, the Board has recognised that stronger domestic conditions could be expected to put upward pressure on inflation in the medium term and that, as a result, further monetary policy tightening could be required. At the same time, prices data prior to receipt of the June quarter CPI were indicating some moderation of current inflation, allowing the Board time for further consideration. The June quarter result, which was available for the Board’s August meeting, signalled that recent inflation had been higher than anticipated and prompted an upward revision to the expected path of inflation in the medium term.
At its August meeting the Board also gave careful consideration to recent developments in global financial markets. The Board noted that credit markets in the United States had experienced some difficulty in recent weeks and that if this persisted it could pose downside risks to the US economy. However, the information to hand suggested these developments were unlikely to cause a major change to the broader global outlook. Growth of the world economy remained strong, and in recent months official forecasts of global growth had been revised upward.
Weighing up all these considerations, the Board judged that a somewhat more restrictive monetary policy setting was required in order to contain inflation in the medium term. Given all the recent information, inflation appears likely to be somewhat higher than earlier expected. Taking into account the effects of the August policy decision, along with other factors including the dampening effect from the appreciation of the Australian dollar, underlying inflation is forecast to be around 3 per cent over the year to December 2007. Ongoing pressures are currently forecast to keep both underlying and CPI inflation near the top of the target range during 2008.
In assessing medium-term prospects it will remain important to keep a close watch on both domestic inflation risks and any further developments in international financial markets and their possible implications for the global economy. The Board will continue to monitor economic and financial market developments and make such adjustments to the policy setting as may be required in order to promote sustainable growth of the economy consistent with the inflation target.